database or retrieval system, without the prior written consent of McGraw-Hill Education, including, but not limited to, in any network or other electronic storage or transmission, or broadcast for distance learning. Some ancillaries, including electronic and print components, may not be available to customers outside the United States. This book is printed on acid-free paper. 1 2 3 4 5 6 7 8 9 0 DOW/DOW 1 0 9 8 7 6 ISBN 978-1-25-927716-0 MHID 1-25-927716-X Senior Vice President, Products & Markets: Kurt L. Strand Vice President, General Manager, Products & Markets: Marty Lange Vice President, Content Production & Technology Services: Kimberly Meriwether David Managing Director: James Heine Executive Brand Manager: Chuck Synovec Senior Director, Product Development: Rose Koos Senior Product Developer: Noelle Bathurst Director of Digital Content: Doug Ruby Digital Development Editor: Tobi Philips Digital Product Analyst: Kevin Shanahan Executive Marketing Manager: Melissa S. Caughlin Content Project Managers: Harvey Yep and Kristin Bradley Design: Debra Kubiak Cover Image: Karol Wójcik /EyeEm/Getty Images Typeface: 10.5/13 Times Roman Compositor: SPi Global Printer: R. R. Donnelley All credits appearing on page or at the end of the book are considered to be an extension of the copyright page. Library of Congress Cataloging-in-Publication Data Block, Stanley B., author. Foundations of financial management / Stanley B. Block, Geoffrey A. Hirt, Bartley R. Danielsen.—Sixteenth edition. pages cm ISBN 978-1-259-27716-0 (alk. paper) 1. Corporations—Finance. I. Hirt, Geoffrey A., author. II. Danielsen, Bartley R., author. III. Title. HG4026.B589 2017 658.15—dc23 2015025324 The Internet addresses listed in the text were accurate at the time of publication. The inclusion of a website does not indicate an endorsement by the authors or McGraw-Hill Education, and McGraw-Hill Education does not guarantee the accuracy of the information presented at these sites.
About the Authors Stanley B. Block Texas Christian University
Geoffrey A. Hirt DePaul University
Bartley R. Danielsen North Carolina State University
Preface Thirty-nine years have passed since we began writing the first edition of this text, and many things have changed during that time. First of all, the field of finance has become much more analytical, with the emphasis on decision-oriented approaches to problems rather than the old, descriptive approach. We have increased the use of analytical approaches to financial problems in virtually every chapter of the book. But we also have stayed with our basic mission of making sure students are able to follow us in our discussions throughout the text. While the 16th edition is considerably more sophisticated than the initial edition, it is still extremely “reader friendly.” As the analytical skills demanded of students have increased, so has the authors’ care in presenting the material. Using computers and calculators has become considerably more important over the last quarter century, and this is also reflected in the 16th edition where we have added Excel tables and calculator keystroke solutions within key chapters. We offer Web Exercises at the end of every chapter, URL citations throughout the text, a library of course materials for students and faculty, computerized testing software and PowerPoint® for the faculty, Connect, an online assignment and assessment solution, and LearnSmart with SmartBook, a truly innovative adaptive study tool and eBook. Throughout the past 39 years, this text has been a leader in bringing the real world into the classroom, and this has never been more apparent than in the 16th edition. Each chapter opens with a real-world vignette and the Finance in Action boxes (found in virtually every chapter) describe real-world activities and decisions made by actual businesses. We are also up-to-date on the latest tax and financial reporting legislation. The international world of finance has become much more important over the last 39 years, and the text has expanded its international coverage tenfold since the first edition. Where there is an international application for a financial issue, you are very likely to find it in this text. Furthermore, the 16th edition gives substantial coverage to the recession and liquidity crisis that has engulfed the U.S. and world economies in the latter part of the 2000–2009 decade (and into the current decade). Special attention is given to the banking sector and the critical need for funding that almost all businesses face. The issue of increased regulation is also covered. However, there is one thing that has not changed over the last 39 years— we still write the entire book and all of the problems ourselves! We believe iv
our devotion of time, energy, and commitment over these years is the reason for our reputation for having produced a high-quality and successful text—edition after edition. Employers of business graduates report that the most successful analysts, planners, and executives are both effective and confident in their financial skills. We concur. One of the best ways to increase your facility in finance is to integrate your knowledge from prerequisite courses. Therefore, the text is designed to build on your basic knowledge from courses in accounting and economics. By applying tools learned in these courses, you can develop a conceptual and analytical understanding of financial management. We realize, however, that for some students time has passed since you have completed your accounting courses. Therefore, we have included Chapter 2, a thorough review of accounting principles, finance terminology, and financial statements. With a working knowledge of Chapter 2, you will have a more complete understanding of the impact of business decisions on financial statements. Furthermore, as you are about to begin your career you will be much better prepared when called upon to apply financial concepts.
Reinforcing Prerequisite Knowledge
In general, tables and figures with real-world numbers have been updated or replaced, and the discussions concerning those tables and figures have been rewritten accordingly. Additionally, we have integrated Excel examples and spreadsheet tables throughout the capital budgeting chapters (Chapters 9 through 12 and Chapter 16). The financial forecasting tables in Chapter 4 have also been updated to mirror the references and style used in Excel spreadsheets.
Chapter-by-Chapter Changes Chapter 1 Coverage of behavioral finance has been added to the section on “Modern Issues in Finance.” A discussion of the latest cases against hedge funds has been included in the discussion of insider trading. Chapter 2 All of the tables have been updated. The discussion of how depreciation, taxes, and cash flows are linked has been clarified. A new Finance in Action box describes corporate “tax inversions” with an explanation of the tax reduction and cash flow enhancing effects that are enjoyed by companies headquartered outside the United States. Chapter 3 The introduction has been updated with information on Colgate-Palmolive vs. Procter and Gamble. American Eagle Outfitters has been replaced with Abercrombie & Fitch in the DuPont model and in the comparison to Walmart. The Apple and IBM comparisons have been updated, and Dell Computer has been eliminated from the comparison. Chapter 4 The financial forecasting Excel material has been updated using colorcoded conventions that have become standard in many financial settings using
Excel. A new Finance in Action box has been added to describe the interaction of Tesla’s marketing and financial forecasting activities. A second Finance in Action box has been written to emphasize the importance of forecasting in entrepreneurs’ development of their business plans. Chapter 5 The introductory airline example has been updated. The Finance in Action box on Japanese companies has been deleted, and the Intel Corporation Finance in Action box on leverage has been revised. Chapter 6 The McGraw-Hill example illustrating seasonal sales and inventory has been replaced with a new example using Briggs & Stratton. Macy’s has replaced Limited Brands in the comparison against Target using seasonal sales and earnings per share. Figures 6-9, 10, 11, and all of the data and discussion about yield curves, interest rates, working capital, and current ratios have been updated. Chapter 7 Figure 7-4 and the discussion of SWIFT have been revised. A new quote from the Federal Reserve Board of Governors has been added. Table 7-1 has been updated. Chapter 8 The discussion of General Electric’s GEC (General Electric Capital) has been updated. Figures 8-1 and 8-2, as well as Table 8-1 have been revised with new data. The Finance in Action box on Internet lending with lending club’s initial public offering has been updated. Chapter 9 A new section has been added at the beginning of the financial calculator material describing how to clear the calculator and set the decimal point. The time value of money presentation has been reworked to include more integrated calculator keystrokes, and a new Finance in Action box has been added to discuss present value in relation to the payment options offered to Powerball winners. New interactive digital illustrations have been added to clarify the graphical time value of money relationships. Chapter 10 The tables have been updated, and the calculator discussion in Appendix 10-B has been significantly enhanced. Chapter 11 The cost of capital material has been revised to illustrate debt costs with calculator keystrokes, the Excel “rate” function, and Excel’s Goal Seek tool. All of the tables have been updated. Chapter 12 The Finance in Action box on real options has been moved to Chapter 13. Chapter 13 All of the tables have been updated. Table 13-4, Table 13-5, and Figure 13-8 have been converted to Excel formats. A Finance in Action box discussing real options has been added to the chapter. Chapter 14 The entire introduction to the chapter has been revised, and the chapter has been updated to reduce the emphasis on the financial crisis. The discussion of the merger (purchase) of the New York Stock Exchange (NYSE) by the Intercontinental Exchange (ICE) has been updated. Additional information on the BATS Exchange has been added. Figure 14-4 has been eliminated, and the other tables and figures have been updated. The Finance in Action box on Bernie Ebbers has been replaced with a new box on dark pools.
Chapter 15 The introduction has been updated to include the IPO by Alibaba and more emphasis on global investment banking. The chapter was heavily revised with new tables and additional discussion of each table. The Finance in Action box on Warren Buffet and Goldman Sachs has been updated. Chapter 16 All tables and real-world examples have been updated. Material linking the time series of Walmart’s leverage levels and times-interest earned ratios to changes in long-term interest rates over the last two decades has been added. Calculator keystrokes have been incorporated throughout the chapter, and IRR calculations are shown using the financial calculator. A Finance in Action box has been added discussing Alibaba’s IPO and six-tranche bond offering. Chapter 17 The introductory example of Ceradyne has been replaced with an example using Tower Jazz, including some global features with plants in Japan. Table 17-1 and the Finance in Action box on Hewlett Packard have been updated. Coverage of global depository receipts has been added to the section on ADRs. Table 17-3 has been replaced with new data and an updated discussion. Chapter 18 The Finance in Action box on Bill Gates has been replaced with a box on Dividend Aristocrats. New Figure 18-2 and Table 18-8 have been added. Tax rate taxes have been modified for 2014, and a discussion about the impact of the Affordable Care Act on dividends for those singles making over $200,000 and those filing jointly making over $250,000 has been added. Chapter 19 New tables and discussions have been added to cover pricing patterns for convertible bonds, characteristics of convertible bonds, successful convertible bonds and preferred stocks not yet called, and warrant prices. Chapter 20 The introduction includes an update on Berkshire Hathaway and information on mergers in the airlines and pharmaceutical companies. A new table and discussion have been added to cover the largest acquisitions ever. Information on tax inversions and hostile merger takeover activities have also been added. Chapter 21 International financial management tables and charts have been updated with current data, and hedging examples using forward and futures contracts have been updated. A new Finance in Action box on how Coca-Cola manages currency risk has been added. Successful improvements from the previous editions that we have built on in the 16th edition include: Functional Integration We have taken care to include examples that are not just applicable to finance students, but also to marketing, management, and accounting majors. Small Business Since over two-thirds of the jobs created in the U.S. economy are from small businesses, we have continued to note when specific financial techniques are performed differently by large and small businesses. Comprehensive International Coverage We have updated and expanded coverage on international companies and events throughout the text. Contemporary Coverage The 16th edition continues to provide updated real-world examples, using companies easily recognizable by students to illustrate financial concepts presented in the text.
in its industry. Ratios that initially appear good or bad may not retain that characteristic when measured against industry peers. There are four main groupings of ratios. Profitability ratios measure the firm’s ability to earn an adequate return on sales, assets, and stockholders’ equity. The asset utilization ratios tell the analyst how quickly the firm is turning over its accounts receivable, inventory, and longer-term assets. Liquidity ratios measure the firm’s ability to pay off short-term obligations as they come due, and debt utilization ratios indicate the overall debt position of the firm in light of its asset base and earning power. The Du Pont system of analysis first breaks down return on assets between the profit margin and asset turnover. The second step shows how this return on assets is translated into return on equity through the amount of debt the firm has. Throughout the analysis, the analyst can better understand how return on assets and return on equity are derived. Over the course of the business cycle, sales and profitability may expand and contract, and ratio analysis for any one year may not present an accurate picture of the Confirmingover Pages firm. Therefore we look at the trend analysis of performance a period of years. A number of factors may distort the numbers accountants actually report. These include the effect of inflation or disinflation, the timing of the recognition of sales as revenue, the treatment of inventory write-offs, the presence of extraordinary gains and losses, and so on. The well-trained financial analyst must be alert to all of these factors.
Integration of Learning Objectives to Discussion Questions and Problems The Learning Objectives (LO) presented Confirming Pages at the beginning of each chapter serve as a quick introduction to the material students will learn and should understand fully before moving to the next chapter. Every discussion question and problemLEARNING at theOBJECTIVES end of each chapter refers back to the learning objective to which it applies. This allows instructors to easily emphasize the Learning Objective(s) as they choose.
LO 3-1 LO 3-2
LO 3-4 LO 3-5
Expanded! Finance in Action Boxes
These boxed readings highlight specific topics of interest that relate to four main areas: managerial decisions, global situations, technology issues, and ethics. The inclusion of ethics is relevant given the many recent corporate scandals and the resulting governance issues. Web addresses are included in applicable boxes for easy access to more information on that topic or company.
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f you’re in the market for dental products, look no further than Colgate-Palmolive. The 1. If we divide users of ratios into short-term lenders, long-term lenders, and firm has it all: every type of toothpaste you can imagine (tartar control, cavity protection, stockholders, which ratios would group be most interested whitening enhancement), as well as every shape andeach size of toothbrush. While you’re in, and for reasons? (LO3-2)its soaps, shampoos, and deodorants (Speed getting ready forwhat the day, also consider Stick, Lady 2. Speed Stick, etc.). Explain how the Du Pont system of analysis breaks down return on assets. Also For those of you who decide to stay home and clean your apartment or dorm room, explain how it breaks down return on stockholders’ equity. (LO3-3) Colgate-Palmolive will provide you with Ajax, Fab, and a long list of other cleaning products. If the interesting, accounts receivable turnover is decreasing, what will be happening All this is3. somewhat but why mention these ratio subjects in a finance text? Well, Colgate-Palmolive somecollection interesting profit numbers over the last three years. Its to has the had average period? (LO3-2) profit margin in 2014 was 13.5 percent, and its return on assets was 31.5 percent. While 4. What advantage does the fixed charge coverage ratio offer over simply using these numbers are higher than those of the average company, the 2014 number that timesisinterest (LO3-2)equity of 167.8 percent (the norm is blows analysts away its returnearned? on stockholders’ 15–20 percent). In fact, this ROE is so high and unrealistic that some financial services list the number as not meaningful (NMF). The major reason for this abnormally high return is its high debt-to-total-asset ratio of 81 percent. This means that the firm’s debt represents 81 percent of total assets and stockholders’ equity only 19 percent. Almost any amount of profit will appear high in regard to the low value of stockholders’ equity. blo7716x_ch03_056-095.indd 74 07/08/15 09:20 AM In contrast, its main competitor, Procter & Gamble, has only a 17.5 percent return on stockholders’ equity, partially because it is heavily financed by stockholders’ equity at 66.2 percent while its debt-to-asset ratio is 33.8 percent. This may be good or bad. This kind of analysis will be found in the financial ratios discussion in this chapter. In Chapter 2, we examined the basic assumptions of accounting and the various components that make up the financial statements of the firm. We now use this fundamental material as a springboard into financial analysis—to evaluate the financial performance of the firm. The format for the chapter is twofold. In the first part we use financial ratios to evaluate the relative success of the firm. Various measures such as net income to sales and current assets to current liabilities will be computed for a hypothetical company and examined in light of industry norms and past trends. In the second part of the chapter we explore the impact of inflation and disinflation on financial operations. You will begin to appreciate the impact of rising prices (or at
Ratio analysis provides a meaningful comparison of a company to its industry. Ratios can be used to measure profitability, asset utilization, liquidity, and debt utilization. The Du Pont system of analysis identifies the true sources of return on assets and return to stockholders. Trend analysis shows company performance over time. Reported income must be further evaluated to identify sources of distortion.
f you’re in the market for dental products, look no further than Colgate-Palmolive. The firm has it all: every type of toothpaste you can imagine (tartar control, cavity protection, whitening enhancement), as well as every shape and size of toothbrush. While you’re getting ready for the day, also consider its soaps, shampoos, and deodorants (Speed Stick, Lady Speed Stick, etc.). For those of you who decide to stay home and clean your apartment or dorm room, Colgate-Palmolive will provide you with Ajax, Fab, and a long list of other cleaning products. All this is somewhat interesting, but why mention these subjects in a finance text? Well, Colgate-Palmolive has had some interesting profit numbers over the last three years. Its profit margin in 2014 was 13.5 percent, and its return on assets was 31.5 percent. While these numbers are higher than those of the average company, the 2014 number that blows analysts away is its return on stockholders’ equity of 167.8 percent (the norm is 15–20 percent). In fact, this ROE is so high and unrealistic that some financial services list the number as not meaningful (NMF). The major reason for this abnormally high return is its high debt-to-total-asset ratio of 81 percent. This means that the firm’s debt represents 81 percent of total assets and stockholders’ equity only 19 percent. Almost any amount of profit will appear high in regard to the low value of stockholders’ equity. In contrast, its main competitor, Procter & Gamble, has only a 17.5 percent return on stockholders’ equity, partially because it is heavily financed by stockholders’ equity at 66.2 percent while its debt-to-asset ratio is 33.8 percent. This may be good or bad. This kind of analysis will be found in the financial ratios discussion in this chapter. In Chapter 2, we examined the basic assumptions of accounting and the various components that make up the financial statements of the firm. We now use this fundamental material as a springboard into financial analysis—to evaluate the financial performance of the firm. The format for the chapter is twofold. In the first part we use financial ratios to evaluate the relative success of the firm. Various measures such as net income to sales and current assets to current liabilities will be computed for a hypothetical company and examined in light of industry norms and past trends. In the second part of the chapter we explore the impact of inflation and disinflation on financial operations. You will begin to appreciate the impact of rising prices (or at
LIST OF TERMS debt utilization ratios profitability ratios LEARNING OBJECTIVES debt to total assets profit margin times ainterest return on assets LO 3-1 Ratio analysis provides meaningfulearned comparison of afixed company to its industry. charge coverage return on equity LO 3-2 Ratios can be used to measure Du Pont system of analysis asset utilization ratios profitability, asset utilization, liquidity, and debt utilization. trend analysis receivable turnover LO 3-3 The Du Pontinflation system of analysis identifies average collection period the true sources of return on assets and replacement costs inventory turnover return to stockholders. LO 3-4 Trend analysis shows company disinflation fixed asset turnover performance over time. deflation total asset turnover LO 3-5 Reported income must be further liquidity ratios evaluated toLIFO identify sources of distortion. FIFO current ratio quick ratio
Revised! Chapter Opening Vignettes
We bring in current events (such as businessto-business online ventures and competition among air carriers) as chapter openers to illustrate the material to be learned in the upcoming chapter.
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Tesla’s Sales Forecasts: Where Marketing and Finance Come Together All the financial analysis in the world can prove useless if a firm does not have a meaningful sales projection. To the extent that the firm has an incorrect sales projection, an inappropriate amount of inventory will be accumulated, projections of accounts receivable and accounts payable will be wrong, and profits and cash flow will be off target. Although a corporate treasurer may understand all the variables influencing income statements, balance sheets, cash budgets, and so on, she is out of luck if the sales projection is wrong. For example, Tesla Motors produces and sells electric cars, and it may have the potential to become the Apple computer of the car industry. However, Tesla’s success partially depends upon gasoline prices. While expensive gas is harmful to the overall economy, it is a sales elixir for Tesla. When oil prices dropped more than 40 percent in 2014, gas prices
Finance in ACTION
plunged, and projections produced by Tesla’s marketing group began to look too rosy. A Morgan Stanley auto analyst estimated that Tesla would sell 40 percent fewer cars than had previously been forecast. Although sales projections had previously been for 500,000 cars by 2020, new projections were for only 300,000. With plummeting oil prices, Tesla’s stock fell over 30 percent. Over the last two decades, the marketing profession has developed many sophisticated techniques for analyzing and projecting future sales, but it is important for financial managers to realize that projections are often inherently risky. The financial manager must look to the marketing staff to help project sales, but a good financial analyst will also seek to determine how risky these sales projections may prove to be. Worst-case scenarios must be recognized so that surprises do not become financial disasters.
We will add the projected quantity of unit sales for the next six months to our desired ending inventory and subtract our stock of beginning inventory (in units) to determine our production requirements. This process is illustrated below. Units 1 Projected sales 1 Desired ending inventory 2 Beginning inventory 5 Production requirements
Following this process, in Table 4-3 we see a required production level of 1,015 wheels and 2,020 casters. Table 4-3 Production requirements for six months A 16 17 18
Projected unit sales (Table 4-1) Desired ending inventory (assumed to represent
A 5 the annuity payment )n 2 1 1 A(1 1 i )n 2 2 . . . A( 1 1 i )1 1 A(1 1 i )0 FVA interest 5 A(1 1 irate i 5 the (1 1 i )n 2 1 n 5 the of payments 5 A ___________ FVA number
Using Formula 9-5 to calculate the future value of our annuity payments, Where
A 5 $1,000 5 future value of an annuity FV Preface ix A
A 5 the annuity payment i 5 10% i 5 the interest rate n 5 4 n 5 the number of payments
(1 1 annuity 0.10) payments, 21 Using Formula 9-5 to calculate the future value_____________ of our FVA 5 $1,000
A 5 $1,000 i 5 10% Because n 5 4 this
problem involves an annuity rather than a single payment, when solv4 ing with a financial calculator,_____________ value (1the 1 0.10) 21that we enter for the PMT key is 2$1,000. FV 5 $1,000 5 $4,641 Now we enter a zero A for the PV 0.10 key. As we computed earlier using the future value FINANCIAL thisequation, problem involves an annuity rather than single payment, when solv-the future value of a of anBecause annuity we find that when thea interest rate is 10%, CALCULATOR ing with$1,000 a financial calculator, the value that we enter for the PMT key is 2$1,000. 4-year, annuity is $4,641. FV of Annuity Now we enter a zero for the PV key. As we computed earlier using the future value Enter Function FV function canthatalso produce the future of value an annuity stream. The FV ofExcel’s an annuity equation, we find when the interest rate is 10%,value the future of a N 4 4-year, $1,000 annuity is $4,641. function assumes that each payment is at the end of a period as shown10in theI/Yprevious Excel’s FV function can also produce the future value of an annuity stream. The FV PMT in cell timeline. The annuity amount is entered as the pmt argument. The 21000 function function assumes that each payment is at the end of a period as shown in the previous 0 usesPVnumbers D1timeline. references the arguments in cells B1 toargument. B4. TheThe function cell D5 The annuity amount is entered as the pmt function in in cell Function Solution D1 references arguments in cells B1 to cases, B4. The the function in cellproduced D5 uses numbers instead of cellthereferences. In both values by the FV CPT function are instead ofto cell references. In both cases, the values produced by the FV function are FV 4,641.00 identical the calculator solution.
FV of Annuity Enter Function N 4 I/Y 10 21000 PMT PV 0 Function CPT FV
In Chapters 9, 10, and 12, the authors have included new discussions on how the examples are solved using Excel, financial calculators, and formulas. Newly formatSolution ted spreadsheet tables and screen captures 4,641.00 detail the step-by-step method to solve the examples. The financial calculator keystrokes in the margins give instructors and students additional flexibility. The material can be presented using traditional methods without loss of clarity because the margin content supplements the prior content, which has been retained. The book and solutions manual provide Excel, calculator, and formula explanations for these very important calculations.
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Part 2 Financial Analysis and Planning Table 5-3
Units Sold 0 20,000 30,000 40,000 60,000 80,000 100,000
Pulling It Together with Color
Volume-cost-profit analysis: Conservative firm Total Variable Costs
0 32,000 48,000
$12,000 12,000 12,000
$ 12,000 44,000 60,000
64,000 96,000 128,000 160,000
12,000 12,000 12,000 12,000
76,000 108,000 140,000 172,000
Total Revenue $
Operating Income (Loss)
0 40,000 60,000
$(12,000) (4,000) 0
80,000 120,000 160,000 200,000
4,000 12,000 20,000 28,000
The Risk Factor Whether management follows the path of the leveraged firm or of the more conservative firm depends on its perceptions of the future. If the vice president of finance is apprehensive about economic conditions, the conservative plan may be undertaken. For a growing business in times of relative prosperity, management might maintain a more aggressive, leveraged position. The firm’s competitive position within its industry will also be a factor. Does the firm desire to merely maintain stability or to become a market leader? To a certain extent, management should tailor the use of leverage to meet its own risk-taking desires. Those who are risk averse (prefer less risk to more risk) should anticipate a particularly high return before contracting for heavy fixed costs. Others, less averse to risk, may be willing to leverage under more normal conditions. Simply taking risks is not a virtue—our prisons are full of risk takers. The important idea, which is stressed throughout the text, is to match an acceptable return with the desired level of risk.
Cash Break-Even Analysis Our discussion to this point has dealt with break-even analysis in terms of accounting flows rather than cash flows. For example, depreciation has been implicitly included in fixed expenses, but it represents a noncash accounting entry rather than an explicit expenditure of funds. To the extent that we were doing break-even analysis on a strictly cash basis, depreciation would be excluded from fixed expenses. In the previous example of the leveraged firm in Formula 5-1, if we eliminate $20,000 of “assumed” depreciation from fixed costs, the break-even level is reduced from 50,000 units to 33,333 units. ($60,000 2 $20,000) $40,000 FC _______ 5 __________________ 5 _______ 5 33,333 units P 2 VC $2.00 2 $0.80 $1.20 Other adjustments could also be made for noncash items. For example, sales may initially take the form of accounts receivable rather than cash, and the same can be said for the purchase of materials and accounts payable. An actual weekly or monthly cash budget would be necessary to isolate these items. While cash break-even analysis is helpful in analyzing the short-term outlook of the firm, particularly when it may be in trouble, break-even analysis is normally
Throughout the 16th edition, the authors make color an integral part of the presentation of finance concepts. Color is applied consistently across illustrations, text, and examples in order to enhance the learning experience. We hope that the color in this edition assists your understanding and retention of the concepts discussed.
New! Digital Illustrations of Time Value of Money (Chapter 9) The concept of the “time value of money” is one of the most difficult topics in any financial management course for professors to communicate to students. We think we have created a visual method for teaching future value and present value of money that will help you understand the concept simply and quickly. The 16th edition includes new interactive digital illustrations of four key figures in the text that visually relate future values and present values. We hope you agree that this visual presentation helps those students who are less comfortable with the math.
1 2 3 4 5
Dp Future Value of an Annuity Due 2. Cost of preferred stock .......................................... Kp 5 _______ 5 10.94% i n pmt FVAD Pp 2 F 10.00%
Present Value of an Annuity Due D1 7 4. Cost of new i common stock n pmt PVAD ................................... Kn 5 ______ 1 g 5 12.60% 8
Review of Formulas At the end of every chapter that includes formulas, we provide a list for easy reviewing purposes.
Practice Problems and Solutions Two practice problems are featured at the end of each chapter. They review concepts illustrated within the chapter and enable the student to determine whether the material has been understood prior to completion of the problem sets. Detailed solutions to the practice problems are found immediately following each problem.
PV(rate, nper, pmt, [fv], [type])
Earnings before taxes (EBT) ........................................................... 2 Taxes (T) 20% ............................................................................ Earnings after taxes (EAT) .............................................................. Shares ............................................................................................ Earnings per share (EPS) ................................................................
$40,000 8,000 $32,000 50,000 $ 0.64
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*8 percent interest 3 $300,000 debt 5 $24,000.
Earnings before interest and taxes (EBIT) ...................................... 2 Interest (I) .................................................................................... Earnings before taxes (EBT) ........................................................... 2 Taxes (T) 20% ............................................................................. Earnings after taxes (EAT) .............................................................. Shares ............................................................................................ Earnings per share (EPS) ................................................................
*Interest on old debt ($24,000) 1 interest on new debt ($20,000). 10 percent 3 $200,000. The total is $44,000. † 50,000 shares reduced by ($200,000/$10 par value) 5 50,000 2 20,000 5 30,000.
PROBLEMS Selected problems are available with Connect. Please see the preface for more information.
Basic Problems 1. Shock Electronics sells portable heaters for $35 per unit, and the variable cost to produce them is $22. Mr. Amps estimates that the fixed costs are $97,500. a. Compute the break-even point in units. b. Fill in the table (in dollars) to illustrate the break-even point has been achieved. Sales ....................................................... 2 Fixed costs ......................................... 2 Total variable costs ............................. Net profit (loss) .......................................
C O M P R E H E N S I V E
P R O B L E M
Medical Research Corporation is expanding its research and production capacity to introduce a new line of products. Current plans call for the expenditure of $100 million on four projects of equal size ($25 million each), but different returns. Project A is in blood clotting proteins and has an expected return of 18 percent. Project B relates to a hepatitis vaccine and carries a potential return of 14 percent. Project C, dealing with a cardiovascular compound, is expected to earn 11.8 percent, and Project D, an investment in orthopedic implants, is expected to show a 10.9 percent return. The firm has $15 million in retained earnings. After a capital structure with $15 million in retained earnings is reached (in which retained earnings represent 60 percent of the financing), all additional equity financing must come in the form of new common stock. Common stock is selling for $25 per share and underwriting costs are estimated at $3 if new shares are issued. Dividends for the next year will be $.90 per share (D1), and earnings and dividends have grown consistently at 11 percent per year. The yield on comparative bonds has been hovering at 11 percent. The investment banker feels that the first $20 million of bonds could be sold to yield 11 percent while additional debt might require a 2 percent premium and be sold to yield 13 percent. The corporate tax rate is 30 percent. Debt represents 40 percent of the capital structure. a. b. c.
The Hartnett Corporation manufactures baseball bats with Pudge Rodriguez’s autograph stamped on them. Each bat sells for $35 and has a variable cost of $22. There are $97,500 in fixed costs involved in the production process. Chapter 11 Cost of Capital a. Compute the break-even point in units. b. Find the sales (in units) needed to earn a profit of $262,500. a. Compute Ki (required rate of return on common equity based on the capital asset pricing model). b. Compute Ke (required rate of return on common equity based on the dividend valuation model).
Several chapters have comprehensive problems that integrate and require the application of several financial concepts into one problem. Additional comprehensive problems are included in the Instructor’s Manual for select chapters.
The marginal cost of capital is also introduced to explain what happens to a company’s cost of capital as it tries to finance a large amount of funds. First the company will LIST OF TERMS use up retained earnings, and the cost of financing will rise as higher-cost new comfuture value present value of an annuity mon stock is substituted for retained earnings in order to maintain the optimal capital present value compounded semiannually structure with the appropriate debt-to-equity ratio. Larger amounts of financial capital discount rate annuity due can also cause the individual means of financing to rise by raising interest rates or by annuity interest factor depressing the price of the stock because more is sold than the market wants to absorb. ordinary annuity yield future value of an annuity REVIEW OF FORMULAS 1. Kd (cost of debt) 5 Y(1 2 T) (11-1) DISCUSSION QUESTIONS Y is yield 1. T How is the future is corporate tax value rate related to the present value of a single sum? (LO9-1) D p sum related to the present value of an annu2. How is the present value of a single of preferred stock) 5 ______ (11-2) 2. K p (cost ity? (LO9-3) Pp 2 F 3. D Why does money have a time value? (LO9-1) p is the annual dividend on preferred stock 4. P Does inflation have anything to do with making a dollar today worth more than a price of preferred stock p is the First Pages dollar tomorrow? (LO9-1) F is flotation, or selling, cost Dfuture 5. Adjust the annual formula for a___ value of a single amount at 12 percent for 1 3. Ke (cost of common equity) 5 1g (11-3) 10 years to a semiannual compounding formula. What are the interest factors P0 ) before and after? they different? (LO9-5) (FVisIFdividend D at the endWhy of theare first year (or period) 1 6. P If,0 as an investor, youstock had atoday choice of daily, monthly, or quarterly compounding, is the price of the 145 wouldrate youinchoose? Why? (LO9-5) Chapter 5 Operating and Financial Leverage gwhich is growth dividends 7. What is a deferred annuity? (LO9-4) (11-4) 4. Kj (required return on common stock) 5 Rf 1 b(Km 2 Rf) 7,000 ($12) 8. R Listisfive different of the$84,000 time value of money. (LO9-1) risk-free rate financial of return applications 5 ________________ 5 ___________________ f 7,000 ($12) 2 $54,000 $84,000 5 $54,000 b is beta coefficient Km is return in$84,000 the marketAND as measured by the appropriate index PRACTICE PROBLEMS SOLUTIONS 5 _______ 5 2.80x D1 you have $30,000 Future value 1. a. You invest $12,000 today at 9 percent per year. How much will 5. Ke (cost of common equity in the form of retained earnings) 5 ___ 1 g (11-5) Present value $44,000 $44,000 after 15_______ years? P0 FC ________ D dividend at the5end of the first year (or period) d.1 isBE 5 5 _______ 5 3,667 fans (LO2&3) b. isWhat current value of $100,000 Pthe 2 2 $8 $12 after 10 years if the discount rate is P price isof theVC stock $20 today 0 12 percent? rate in dividends 2. ga.is growth Earnings before interest and taxes $64,000 c. You invest $2,000 a year for 20(EBIT) years...................................... at 11 percent. How much will you have 2 Interest (I) .................................................................................... 24,000* after 20 years?
Labeled Discussion Questions and Problems The material in the text is supported by over 250 questions and 475 problems in this edition, to reinforce and test your understanding of each chapter. Care has been taken to make the questions and problems consistent with the chapter material, and each problem is labeled with its topic, learning objective, and level of difficulty to facilitate that link. Every problem and solution has been written by the authors, and all of the quantitative problems are assignable in Connect.
D ___1 [pv], [type]) 3. Cost of common equity (retained earnings) FV(rate, ........... nper, Ke 5pmt, 1g5 12% P0
T 5 Corporate tax rate, 35% Dp 5 Preferred dividend, $10.50 Pp 5 Price of preferred stock, $100 F 5 Flotation costs, $4 D1 5 First year common dividend, $2 P0 5 Price of common stock, $40 g 5 Growth rate, 7% Same as above, with F 5 Flotation costs, $4
Based on the two sources of financing, what is the initial weighted average cost of capital? (Use Kd and Ke.) At what size capital structure will the firm run out of retained earnings? What will the marginal cost of capital be immediately after that point?
First Pages Break-even analysis
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Medical Research Corporation
(Marginal cost of capital and investment returns) (LO11-5)
Ratio Applied to Earnings per Share in Chapter 2. 7.
The book values per share for the same four years discussed in the preceding question were 1998 $1.18 1999 $1.55 2000 $2.29 2001 $3.26
Preface xi a. Compute the ratio of price to book value for each year. b. Is there any dramatic shift in the ratios worthy of note?
W E B
E X E R C I S E 1.
2. 3. 4.
IBM was mentioned in the chapter as having an uneven performance. Let’s check this out. Go to its website, www.ibm.com, and follow the steps below. Under “Information for” at the bottom of the page, select “Investors.” Select “Financial Snapshot” on the next page. Click on “Stock Chart.” How has IBM’s stock been doing recently? Click on “Financial Snapshot.” Assuming IBM’s historical price-earnings ratio is 18, how does it currently stand? Assuming its annual dividend yield is 2.5 percent, how does it currently stand?
Each chapter includes at least one Web exercise to help pull more relevant real-world material into the classroom. The exercises ask students to go to a specific website of a company and make a complete analysis similar to that demonstrated in the chapter. These exercises provide a strong link between learning chapter concepts and applying them to the actual decision-making process.
07/08/15 09:33 AM
Less Managing. More Teaching. Greater Learning.
McGraw-Hill Connect McGraw-Hill Connect is an online assignment and assessment
solution aid that connects students with the tools and resources they’ll need to achieve success. McGraw-Hill Connect helps prepare students for their future by enabling faster learning, more efficient studying, and higher retention of knowledge.
McGraw-Hill Connect Features Connect offers a number of powerful tools and features to make managing assignments easier, so faculty can spend more time teaching. With Connect, students can engage with their coursework anytime and anywhere, making the learning process more accessible and efficient. Connect offers you the features described next. Simple Assignment Management With Connect, creating assignments is easier than ever, so you can spend more time teaching and less time managing. The assignment management function enables you to: ∙ Create and deliver assignments easily with selectable end-of-chapter questions and test bank items. ∙ Streamline lesson planning, student progress reporting, and assignment grading to make classroom management more efficient than ever. ∙ Go paperless with the SmartBook eBook and online submission and grading of student assignments. Smart Grading When it comes to studying, time is precious. Connect helps students learn more efficiently by providing feedback and practice material when they need it, where they need it. When it comes to teaching, your time also is precious. The grading function enables you to: ∙ Have assignments scored automatically, giving students immediate feedback on their work and side-by-side comparisons with correct answers. ∙ Access and review each response; manually change grades or leave comments for students to review. ∙ Reinforce classroom concepts with practice tests and instant quizzes.
Instructor Library The Connect Instructor Library is your repository for additional resources to improve student engagement in and out of class. You can select and use any asset that enhances your lecture. This library contains information about the book and the authors, as well as all of the instructor supplements for this text, including: ∙ Instructor’s Manual Revised by author Geoff Hirt, the manual helps instructors integrate the graphs, tables, perspectives, and problems into a lecture format. Each chapter opens with a brief overview and a review of key chapter concepts. The chapter is then outlined in an annotated format to be used as an in-class reference guide by the instructor. ∙ Solutions Manual Updated by author Bart Danielsen, the manual includes detailed solutions to all of the questions and problems, set in a larger type font to facilitate their reproduction in the classroom. Calculator, Excel, and formula solutions are included for all relevant problems. ∙ Test Bank This question bank includes over 1,500 multiple-choice and true/false questions, with revisions and updates made by Katie Landgraf, University of Hawaii. Updates to the questions correspond to the revisions in the 16th edition. Also included are short answer questions and matching quizzes. The test bank is assignable in Connect and EZ Test Online and available as Word files. ∙ PowerPoint Presentations These slides, updated by Leslie Rush, University of Hawaii, contain lecture outlines and selected exhibits from the book in a fourcolor, electronic format that you can customize for your own lectures. Student Study Materials The Connect Student Study Center is the place for students to access additional resources. The Student Study Center: ∙ Offers students quick access to lectures, course materials, eBooks, and more. ∙ Provides instant practice material and study questions, easily accessible on the go. Diagnostic and Adaptive Learning of Concepts: LearnSmart and SmartBook Students want to make the best use of their study time. The LearnSmart adaptive selfstudy technology within Connect provides students with a seamless combination of practice, assessment, and remediation for every concept in the textbook. LearnSmart’s intelligent software adapts to every student response and automatically delivers concepts that advance students’ understanding while reducing time devoted to the concepts already mastered. The result for every student is the fastest path to mastery of the chapter concepts. LearnSmart: ∙ Applies an intelligent concept engine to identify the relationships between concepts and to serve new concepts to each student only when he or she is ready. ∙ Adapts automatically to each student, so students spend less time on the topics they understand and practice more those they have yet to master. ∙ Provides continual reinforcement and remediation but gives only as much guidance as students need. ∙ Integrates diagnostics as part of the learning experience. ∙ Enables instructors to assess which concepts students have efficiently learned on their own, thus freeing class time for more applications and discussion.
SmartBook®, powered by LearnSmart, is the first and only adaptive reading experience designed to change the way students read and learn. It creates a personalized reading experience by highlighting the most impactful concepts a student needs to learn at that moment in time. As a student engages with SmartBook, the reading experience continuously adapts by highlighting content based on what the student knows and doesn’t know. This ensures that the focus is on the content he or she needs to learn, while simultaneously promoting long-term retention of material. Use SmartBook’s real-time reports to quickly identify the concepts that require more attention from individual students – or the entire class. The end result? Students are more engaged with course content, can better prioritize their time, and come to class ready to participate. Student Progress Tracking Connect keeps instructors informed about how each student, section, and class is performing, allowing for more productive use of lecture and office hours. The progresstracking function enables you to: ∙ View scored work immediately and track individual or group performance with assignment and grade reports. ∙ Access an instant view of student or class performance relative to learning objectives. ∙ Collect data and generate reports required by many accreditation organizations, such as AACSB. For more information about Connect, go to connect.mheducation.com or contact your local McGraw-Hill sales representative.
Acknowledgments We are extremely grateful to the following instructors for their valuable reviews on previous editions: Alan Adams Ahmed Al Asfour Dwight C. Anderson Eric Anderson Andreas Andrikopoulos Antonio Apap Kavous Ardalan John Backman Charles Barngrover Larry Barraza Brian T. Belt James Benedum Omar Benkato Michael Bentil
Joseph Bentley William J. Bertin Debela Birru Robert Boatler Walter Boyle Wendell Bragg Alka Bramhandkar Jeb Briley Dallas Brozik Georgia Buckles Richard Burton Richard Butler Ezra Byler Kevin Cabe
Rosemary Carlson Alan J. Carper Cheryl Chamblin Leo Chan Rolf Christensen Steven Christian Andreas Christofi E. Tylor Claggett Margaret Clark Henry Co Nanette Cobb Allan Conway Tom Copeland Walter R. Dale
Jeffrey S. Dean Andrea DeMaskey James Demello Bob Diberio Clifford A. Diebold Darla Donaldson Jeff Donaldson Tom Downs David Durst Fred Ebeid Scott Ehrhorn Jeff Eicher Marumbok Etta Michael Evans Gregory Fallon Barry Farber George Fickenworth O. L. Fortier Mike Fioccoprile Gary Florence Mohamed Gaber Robert Gaertner Jim Gahlon Ashley Geisewite James Gentry Elizabeth Goins Bernie J. Grablowsky Bill Greer Debbie Griest Kidane Habteselassie John R. Hall Thomas R. Hamilton Walt Hammond Frank Harber Carole Harris Eric Haye Charles Higgins Eric Hoogstra Stanley Jacobs Bharat Jain Jerry James Joel Jankowski Victoria Javine Gerald S. Justin Fredric S. Kamin Moonsoo Kang
Peter R. Kensicki Tom Kewley Jim Keys Robert Kleiman Ken Knauf Raj Kohli Charles Kronche Ronald Kudla Morris Lamberson Linda Lange Joe Lavely Sharon Lee Joseph Levitsky John H. Lewis Terry Lindenberg Joe Lipscomb John P. Listro Wilson Liu Jim Lock Doug Lonnstrom Leslie Lukasik Claude Lusk Kelly Manley Ken Mannino Paul Marciano John D. Markese Peter Marks Thomas Maroney Kooros Maskooki Bill Mason Joe Massa John Masserwick Patricia Matthews Michael Matukonis K. Gary McClure Grant McQueen Wayne E. McWee Stuart Michelson Vassil Mihov Jerry D. Miller David Minars Mike Moritz Heber Moulton Matt Muller Vivian Nazar Srinivas Nippani
Kenneth O’Brien Bryan O’Neil Dimitrios Pachis Coleen C. Pantalone Robert Pavlik Rosemary C. Peavler Mario Picconi Beverly Piper Harlan Platt Ralph A. Pope Roger Potter Franklin Potts Dev Prasad Cynthia Preston Chris Prestopino Frances A. Quinn James Racic David Rankin Dan Raver Robert Rittenhouse Mauricio Rodriguez Frederick Rommel Marjorie Rubash Gary Rupp Philip Russel Gayle Russell Robert Saemann Olgun Fuat Sahin Ajay Samant Atul Saxena Timothy Scheppa Sandra Schickele James Scott Abu Selimuddin Gowri Shankar Joanne Sheridan Fred Shipley Larry Simpson Larry Smith William Smith Jan R. Squires Sundaram Srinivasan Cliff Stalter Jack Stone Thad Stupi Diane Suhler
Mark Sunderman Robert Swanson Tom Szczurek Glenn Tanner Richard Taylor Robert Taylor Mike Toyne Mike Tuberose Cathyann Tully Lana Tuss
Mark Vaughan Donald E. Vaughan Andrew Waisburd Ken Washer William Welch Gary Wells Larry White Howard R. Whitney Philip L. Wiggle Lawrence Wolken
Annie Wong Don Wort Ergun Yener Lowell Young Emily Zeitz Terry Zivney Linda Wiechowski Matt Wirgau Charles Zellerbach Miranda Zhang
We would like to give special thanks to John Plamondon for his excellent data gathering using DePaul’s Bloomberg terminals and his construction of figures and tables in many of the chapters. Marisa Evans, David Golder, Henry Stilley, Chelsea Tate, Katherine Boliek, Chase Crone, Cameron Monahan, Munroe Danielsen, and Ashley Smith have been invaluable in assisting with text, solutions, and Connect content. We would also like to thank Noelle Bathurst, senior product developer; Chuck Synovec, executive brand manager; Harvey Yep, content project manager; Melissa Caughlin, senior marketing manager; Kevin Shanahan, digital product analyst; Doug Ruby, director of digital content; Kristin Bradley, assessment project manager; Debra Kubiak, lead designer; and the entire team at McGraw-Hill for its feedback, support, and enduring commitment to excellence. Stanley B. Block Geoffrey A. Hirt Bartley R. Danielsen
Brief Contents PART 1
1The Goals and Activities of Financial
14 Capital Markets 452 15 Investment Banking: Public and Private
| F INANCIAL ANALYSIS AND PLANNING
2Review of Accounting 25 3Financial Analysis 56 4Financial Forecasting 96 5Operating and Financial Leverage 125
| WORKING CAPITAL MANAGEMENT 6Working Capital and the Financing
Decision 158 7Current Asset Management 191 8Sources of Short-Term Financing 227 PART 4
| T HE CAPITAL BUDGETING PROCESS 9The Time Value of Money 256 10 Valuation and Rates of Return 295 11 Cost of Capital 341 12 The Capital Budgeting Decision 380 13 Risk and Capital Budgeting 418
| LONG-TERM FINANCING
Placement 473 Long-Term Debt and Lease Financing 503 Common and Preferred Stock Financing 543 Dividend Policy and Retained Earnings 574 Convertibles, Warrants, and Derivatives 604
| EXPANDING THE PERSPECTIVE OF CORPORATE FINANCE 20 External Growth through Mergers 631 21 International Financial
6. Expanding the Perspective of Corporate Finance 21 List of Terms 22 Discussion Questions 22 Web Exercise 23
1 The Goals and Activities of Financial Management 2 The Field of Finance 3 Evolution of the Field of Finance 3 Modern Issues in Finance 4 Risk Management and a Review of the Financial Crisis 4 The Dodd–Frank Act 5 The Impact of Information Technology 6 Activities of Financial Management 7 Forms of Organization 8 Sole Proprietorship 8 Partnership 9 Corporation 9 Corporate Governance 11 The Sarbanes–Oxley Act 12 Goals of Financial Management 12 A Valuation Approach 13 Maximizing Shareholder Wealth 13 Management and Stockholder Wealth 14 Social Responsibility and Ethical Behavior 14 The Role of the Financial Markets 16 Structure and Functions of the Financial Markets 17 Allocation of Capital 17 Institutional Pressure on Public Companies to Restructure 18 Internationalization of the Financial Markets 19 Information Technology and Changes in the Capital Markets 19 Format of the Text 20 Parts 20 1. Introduction 20 2. Financial Analysis and Planning 21 3. Working Capital Management 21 4. The Capital Budgeting Process 21 5. Long-Term Financing 21
| FINANCIAL ANALYSIS AND PLANNING 2 Review of Accounting 25 Income Statement 26 Return to Capital 27 Price-Earnings Ratio Applied to Earnings per Share 27 Limitations of the Income Statement 28 Balance Sheet 29 Interpretation of Balance Sheet Items 29 Concept of Net Worth 31 Limitations of the Balance Sheet 31 Statement of Cash Flows 33 Developing an Actual Statement 33 Determining Cash Flows from Operating Activities 34 Determining Cash Flows from Investing Activities 37 Determining Cash Flows from Financing Activities 37 Combining the Three Sections of the Statement 38 Depreciation and Funds Flow 41 Free Cash Flow 43 Income Tax Considerations 43 Corporate Tax Rates 43 Cost of a Tax-Deductible Expense 44 Depreciation as a Tax Shield 44 Summary 45 List of Terms 45 Discussion Questions 46 Practice Problems and Solutions 46 Problems 47 Web Exercise 55
3 Financial Analysis 56
Discussion Questions 112 Practice Problems and Solutions 112 Problems 113 Comprehensive Problem 122 Comprehensive Problem 123 Web Exercise 124
Ratio Analysis 57 Classification System 57 The Analysis 58 A. Profitability Ratios 59 B. Asset Utilization Ratios 62 C. Liquidity Ratios 63 D. Debt Utilization Ratios 63 Trend Analysis 65 Impact of Inflation on Financial Analysis 67 An Illustration 69 Disinflation Effect 70 Deflation 71 Other Elements of Distortion in Reported Income 71 Explanation of Discrepancies 71 Sales 71 Cost of Goods Sold 72 Extraordinary Gains/Losses 72 Net Income 73 Summary 74 List of Terms 74 Discussion Questions 74 Practice Problems and Solutions 75 Problems 78 Comprehensive Problem 89 Comprehensive Problem 91 Web Exercise 94
5 Operating and Financial Leverage 125 Leverage in a Business 126 Operating Leverage 126 Break-Even Analysis 126 A More Conservative Approach 128 The Risk Factor 130 Cash Break-Even Analysis 130 Degree of Operating Leverage 131 Leveraged Firm 131 Conservative Firm 132 Limitations of Analysis 133 Financial Leverage 133 Impact on Earnings 134 Degree of Financial Leverage 136 Plan A (Leveraged) 137 Plan B (Conservative) 137 Limitations to Use of Financial Leverage 137 Combining Operating and Financial Leverage 137 Degree of Combined Leverage 139 A Word of Caution 140 Summary 142 Review of Formulas 142 List of Terms 143 Discussion Questions 143 Practice Problems and Solutions 144 Problems 145 Comprehensive Problem 154 Web Exercise 156
4 Financial Forecasting 96 Constructing Pro Forma Statements 97 Pro Forma Income Statement 98 Establish a Sales Projection 98 Determine a Production Schedule and the Gross Profit 98 Cost of Goods Sold 100 Other Expense Items 101 Actual Pro Forma Income Statement 101 Cash Budget 102 Cash Receipts 102 Cash Payments 103 Actual Budget 104 Pro Forma Balance Sheet 105 Explanation of Pro Forma Balance Sheet 107 Analysis of Pro Forma Statement 108 Percent-of-Sales Method 108 Summary 111 List of Terms 111
| WORKING CAPITAL MANAGEMENT 6 Working Capital and the Financing Decision 158 The Nature of Asset Growth 159 Controlling Assets—Matching Sales and Production 160 Temporary Assets under Level Production—An Example 164
Contents xix Patterns of Financing 168 Alternative Plans 170 Long-Term Financing 170 Short-Term Financing (Opposite Approach) 170 The Financing Decision 171 Term Structure of Interest Rates 173 A Decision Process 176 Introducing Varying Conditions 177 Expected Value 177 Shifts in Asset Structure 178 Toward an Optimal Policy 179 Summary 181 List of Terms 182 Discussion Questions 182 Practice Problems and Solutions 182 Problems 184 Web Exercise 190
7 Current Asset Management 191 Cash Management 192 Reasons for Holding Cash Balances 192 Cash Flow Cycle 192 Collections and Disbursements 194 Float 196 Improving Collections 196 Extending Disbursements 196 Cost-Benefit Analysis 197 Electronic Funds Transfer 198 International Cash Management 198 Marketable Securities 200 Management of Accounts Receivable 204 Accounts Receivable as an Investment 204 Credit Policy Administration 205 Credit Standards 205 Terms of Trade 208 Collection Policy 209 An Actual Credit Decision 209 Inventory Management 210 Level versus Seasonal Production 211 Inventory Policy in Inflation (and Deflation) 211 The Inventory Decision Model 211 Carrying Costs 212 Ordering Costs 212 Economic Ordering Quantity 213 Safety Stock and Stockouts 214 Just-in-Time Inventory Management 215
Cost Savings from Lower Inventory 216 Other Benefits 216 The Downside of JIT 216 Summary 217 List of Terms 218 Discussion Questions 218 Practice Problems and Solutions 219 Problems 220 Comprehensive Problem 225 Web Exercise 226
8 Sources of Short-Term Financing 227 Trade Credit 228 Payment Period 228 Cash Discount Policy 228 Net Credit Position 229 Bank Credit 229 Prime Rate and LIBOR 230 Compensating Balances 230 Maturity Provisions 233 Cost of Commercial Bank Financing 233 Interest Costs with Compensating Balances 234 Rate on Installment Loans 234 Annual Percentage Rate 235 The Credit Crunch Phenomenon 235 Financing through Commercial Paper 236 Advantages of Commercial Paper 238 Limitations on the Issuance of Commercial Paper 238 Foreign Borrowing 239 Use of Collateral in Short-Term Financing 240 Accounts Receivable Financing 240 Pledging Accounts Receivable 241 Factoring Receivables 241 Asset-Backed Public Offerings 242 Inventory Financing 243 Stages of Production 243 Nature of Lender Control 243 Blanket Inventory Liens 243 Trust Receipts 243 Warehousing 243 Appraisal of Inventory Control Devices 244 Hedging to Reduce Borrowing Risk 245 Summary 246 List of Terms 247
Contents Discussion Questions 247 Practice Problems and Solutions 248 Problems 249 Web Exercise 254
| T HE CAPITAL BUDGETING PROCESS 9 The Time Value of Money 256 Relationship to the Capital Outlay Decision 256 Future Value—Single Amount 257 Present Value—Single Amount 260 Interest Rate—Single Amount 262 Number of Periods—Single Amount 263 Future Value—Annuity 264 Present Value—Annuity 266 Alternative Calculations: Using TVM Tables 267 Graphical Presentation of Time Value Relationships 267 The Relationship between Present Value and Future Value 267 The Relationship between the Present Value of a Single Amount and the Present Value of an Annuity 269 Future Value Related to the Future Value of an Annuity 270 Determining the Annuity Value 272 Annuity Equaling a Future Value 272 Annuity Equaling a Present Value 272 Finding Annuity Payments with a Financial Calculator or Excel 273 Finding Interest Rates and the Number of Payments 274 Finding Annuity Interest Rates 274 Finding the Number of Annuity Payments 275 Compounding over Additional Periods 275 Patterns of Payment with a Deferred Annuity 276 Annuities Due 278 List of Terms 279 Discussion Questions 279 Practice Problems and Solutions 279 Problems 281 Comprehensive Problem 286
Web Exercise 287 Appendix 9A Alternative Calculations: Using TVM Tables 288 Appendix 9B Yield and Payment Examples Using TVM Tables 291
10 Valuation and Rates of Return 295 Valuation Concepts 296 Valuation of Bonds 296 Present Value of Interest Payments 298 Present Value of Principal Payment (Par Value) at Maturity 298 Bond Valuation Using a Financial Calculator 298 Using Excel’s PV Function to Calculate a Bond Price 299 Concept of Yield to Maturity 299 Changing the Yield to Maturity and the Impact on Bond Valuation 301 Increase in Inflation Premium 301 Decrease in Inflation Premium 302 Time to Maturity 303 Determining Yield to Maturity from the Bond Price 303 Semiannual Interest and Bond Prices 307 Valuation and Preferred Stock 307 Determining the Required Rate of Return (Yield) from the Market Price 309 Valuation of Common Stock 310 No Growth in Dividends 310 Constant Growth in Dividends 310 Stock Valuation Based on Future Stock Value 312 Determining the Required Rate of Return from the Market Price 313 The Price-Earnings Ratio Concept and Valuation 314 Variable Growth in Dividends 315 Summary and Review of Formulas 317 Bonds 317 Preferred Stock 318 Common Stock 318 List of Terms 319 Discussion Questions 319 Practice Problems and Solutions 320 Problems 321 Comprehensive Problem 328 Web Exercise 329
Contents xxi Appendix 10A Valuation of a Supernormal Growth Firm 330 Appendix 10B Using Calculators for Financial Analysis 332
11 Cost of Capital 341 The Overall Concept 341 Cost of Debt 342 Cost of Preferred Stock 344 Cost of Common Equity 345 Valuation Approach 345 Required Return on Common Stock Using the Capital Asset Pricing Model 346 Cost of Retained Earnings 347 Cost of New Common Stock 348 Overview of Common Stock Costs 349 Optimum Capital Structure—Weighting Costs 349 Capital Acquisition and Investment Decision Making 351 Cost of Capital in the Capital Budgeting Decision 352 The Marginal Cost of Capital 354 Summary 358 Review of Formulas 359 List of Terms 360 Discussion Questions 360 Practice Problems and Solutions 361 Problems 363 Comprehensive Problem 371 Comprehensive Problem 371 Web Exercise 372 Appendix 11A Cost of Capital and the Capital Asset Pricing Model 373 List of Terms 379 Discussion Questions 379 Problems 379
12 The Capital Budgeting Decision 380 Administrative Considerations 381 Accounting Flows versus Cash Flows 381 Methods of Ranking Investment Proposals 383 Payback Method 384 Net Present Value 385 Internal Rate of Return 387 Selection Strategy 389 Reinvestment Assumption 390 Modified Internal Rate of Return 391
Capital Rationing 392 Net Present Value Profile 393 Characteristics of Investment C 394 Combining Cash Flow Analysis and Selection Strategy 396 The Rules of Depreciation 397 The Tax Rate 399 Actual Investment Decision 399 The Replacement Decision 400 Sale of Old Asset 401 Incremental Depreciation 402 Cost Savings 403 Elective Expensing 404 Summary 405 List of Terms 405 Discussion Questions 405 Practice Problems and Solutions 406 Problems 407 Comprehensive Problem 416 Web Exercise 417
13 Risk and Capital Budgeting 418 Definition of Risk in Capital Budgeting 418 The Concept of Risk-Averse 420 Actual Measurement of Risk 420 Risk and the Capital Budgeting Process 423 Risk-Adjusted Discount Rate 424 Increasing Risk over Time 425 Qualitative Measures 425 Example—Risk-Adjusted Discount Rate 427 Simulation Models 428 Decision Trees 428 The Portfolio Effect 430 Portfolio Risk 430 Evaluation of Combinations 434 The Share Price Effect 435 Summary 435 Review of Formulas 436 List of Terms 436 Discussion Questions 436 Practice Problems and Solutions 437 Problems 438 Comprehensive Problem 448 Comprehensive Problem 449 Web Exercise 450
xxii PART 5
| LONG-TERM FINANCING 14 Capital Markets 452 International Capital Markets 453 Competition for Funds in the U.S. Capital Markets 455 Government Securities 455 U.S. Government Securities 455 Federally Sponsored Credit Agencies 455 State and Local Securities 456 Corporate Securities 456 Corporate Bonds 456 Preferred Stock 456 Common Stock 456 Internal versus External Sources of Funds 457 The Supply of Capital Funds 458 The Role of the Security Markets 460 The Organization of the Security Markets 460 Traditional Organized Exchanges 460 Listing Requirements for Firms 461 Electronic Communication Networks (ECNs) 461 BATS 462 The New York Stock Exchange 462 The NASDAQ Market 463 Foreign Exchanges 464 Other Financial Exchanges 464 Market Efficiency 464 The Efficient Market Hypothesis 466 Regulation of the Security Markets 467 The Securities Act of 1933 467 The Securities Exchange Act of 1934 468 The Securities Acts Amendments of 1975 469 The Sarbanes–Oxley Act of 2002 469 Summary 470 List of Terms 471 Discussion Questions 471 Web Exercise 472
15 Investment Banking 473 The Role of Investment Banking 474 Investment Banking Competition 475 Enumeration of Functions 475 Underwriter 475
Market Maker 476 Advisor 476 Agency Functions 476 The Distribution Process 477 The Spread 478 Pricing the Security 479 Debt versus Equity Offerings 481 Dilution 481 Market Stabilization 482 Aftermarket 483 Shelf Registration 484 The Gramm–Leach–Bliley Act Repeals the Glass–Steagall Act 484 Public versus Private Financing 485 Advantages of Being Public 485 Disadvantages of Being Public 485 Public Offerings 486 A Classic Example—Rosetta Stone Goes Public 486 Private Placement 489 Going Private and Leveraged Buyouts 489 International Investment Banking Deals 491 Privatization 491 Summary 492 List of Terms 492 Discussion Questions 493 Practice Problems and Solutions 493 Problems 494 Comprehensive Problem 500 Web Exercise 502
16 Long-Term Debt and Lease Financing 503 The Expanding Role of Debt 503 The Debt Contract 505 Par Value 505 Coupon Rate 505 Maturity Date 505 Security Provisions 505 Unsecured Debt 506 Methods of Repayment 507 Serial Payments 507 Sinking-Fund Provision 507 Conversion 507 Call Feature 508 An Example: Eli Lilly’s 6.77 Percent Bond 508
Contents xxiii Bond Prices, Yields, and Ratings 508 Bond Yields 510 Nominal Yield (Coupon Rate) 511 Current Yield 511 Yield to Maturity 511 Bond Ratings 511 Examining Actual Bond Ratings 512 The Refunding Decision 513 A Capital Budgeting Problem 513 Step A—Outflow Considerations 514 Step B—Inflow Considerations 515 Step C—Net Present Value 516 Other Forms of Bond Financing 517 Advantages and Disadvantages of Debt 518 Benefits of Debt 518 Drawbacks of Debt 519 Eurobond Market 519 Leasing as a Form of Debt 519 Capital Lease versus Operating Lease 521 Income Statement Effect 522 Advantages of Leasing 522 Summary 523 List of Terms 523 Discussion Questions 524 Practice Problems and Solutions 525 Problems 527 Comprehensive Problem 532 Web Exercise 532 Appendix 16A Financial Alternatives for Distressed Firms 533 Out-of-Court Settlement 533 In-Court Settlements—Formal Bankruptcy 534 Reorganization 534 Liquidation 534 List of Terms 538 Discussion Questions 538 Problem 538 Appendix 16B Lease-versus-Purchase Decision 539 Problem 542
17 Common and Preferred Stock Financing 543 Common Stockholders’ Claim to Income 544 The Voting Right 545 Cumulative Voting 546
The Right to Purchase New Shares 549 The Use of Rights in Financing 550 Rights Required 551 Monetary Value of a Right 551 Effect of Rights on Stockholder’s Position 553 Desirable Features of Rights Offerings 554 Poison Pills 555 American Depository Receipts 556 Preferred Stock Financing 557 Justification for Preferred Stock 558 Investor Interest 558 Summary of Tax Considerations 559 Provisions Associated with Preferred Stock 559 1. Cumulative Dividends 559 2. Conversion Feature 559 3. Call Feature 560 4. Participation Provision 560 5. Floating Rate 560 6. Auction Rate Preferred Stock 560 7. Par Value 561 Comparing Features of Common and Preferred Stock and Debt 561 Summary 563 Review of Formulas 563 List of Terms 564 Discussion Questions 564 Practice Problems and Solutions 565 Problems 566 Comprehensive Problem 571 Comprehensive Problem 572 Web Exercise 573
18 Dividend Policy and Retained Earnings 574 The Marginal Principle of Retained Earnings 575 Life Cycle Growth and Dividends 575 Dividends as a Passive Variable 577 An Incomplete Theory 577 Arguments for the Relevance of Dividends 577 Dividend Stability 579 Other Factors Influencing Dividend Policy 581 Legal Rules 581 Cash Position of the Firm 582
Contents Access to Capital Markets 582 Desire for Control 582 Tax Position of Shareholders 583 Dividend Payment Procedures 584 Stock Dividend 585 Accounting Considerations for a Stock Dividend 585 Value to the Investor 586 Possible Value of Stock Dividends 587 Use of Stock Dividends 587 Stock Splits 587 Reverse Stock Splits 588 Repurchase of Stock as an Alternative to Dividends 589 Other Reasons for Repurchase 590 Dividend Reinvestment Plans 592 Summary 593 List of Terms 593 Discussion Questions 593 Practice Problems and Solutions 594 Problems 595 Comprehensive Problem 602 Web Exercise 603
19 Convertibles, Warrants, and Derivatives 604 Convertible Securities 605 Value of the Convertible Bond 605 Is This Fool’s Gold? 608 Advantages and Disadvantages to the Corporation 609 Forcing Conversion 610 Accounting Considerations with Convertibles 611 Financing through Warrants 613 Valuation of Warrants 614 Use of Warrants in Corporate Finance 617 Accounting Considerations with Warrants 617 Derivative Securities 618 Options 618 Futures 619 Summary 620 Review of Formulas 621 List of Terms 621 Discussion Questions 621 Practice Problems and Solutions 622 Problems 623
Comprehensive Problem 628 Comprehensive Problem 629 Web Exercise 629
| EXPANDING THE PERSPECTIVE OF CORPORATE FINANCE 20 External Growth through Mergers 631 Motives for Business Combinations 633 Financial Motives 633 Portfolio Effect 633 Access to Financial Markets 634 Tax Inversions 634 Tax Loss Carryforward 635 Nonfinancial Motives 637 Motives of Selling Stockholders 637 Terms of Exchange 637 Cash Purchases 638 Stock-for-Stock Exchange 639 Portfolio Effect 640 Accounting Considerations in Mergers and Acquisitions 641 Negotiated versus Tendered Offers 642 Premium Offers and Stock Price Movements 645 Two-Step Buyout 645 Summary 647 List of Terms 647 Discussion Questions 647 Practice Problems and Solutions 648 Problems 649 Web Exercise 653
21 International Financial Management 655 The Multinational Corporation: Nature and Environment 657 Exporter 658 Licensing Agreement 658 Joint Venture 658 Fully Owned Foreign Subsidiary 658 Foreign Exchange Rates 659 Factors Influencing Exchange Rates 660 Purchasing Power Parity 661 Interest Rates 661 Balance of Payments 661 Government Policies 661 Other Factors 662